A shake-out in the City as important as Big Bang
Within 18 months share deals on the Stock Exchange will take place with hardly any humans involved. John Willcock reports
Friday 28 March 1997
The reason is the planned introduction by the London Stock Exchange this October of an innocuous sounding new system of trading shares, called "order-driven" trading.
Although this will only affect FTSE 100 stocks to start with, the ditching of the traditional British "quote-driven" system will have seismic repercussions for players in the market.
There will be winners and losers. As usual, the winners are likely to be the biggest players with the most capital to throw at the required changes.
Some are even predicting that among the 30-odd houses that make markets in UK equities at the moment, just four or five will come to dominate the new market.
David Balls, head of UK market-making at SBC Warburg, says that the introduction of order-driven trading "is as important as Big Bang. It will mean a dramatic change in the way business is done."
"A raft of market-makers will either change skills or look elsewhere. There will be a lot of upheaval, and the people who will benefit from it will be those who can adapt to change quickly."
The London Stock Exchange itself describes it as the equity market's "most significant development in over a decade".
In essence, the present system of quote-driven share trading entails market-makers putting out quotes for prices and sizes they are prepared to trade at on the Seaq screen for any particular stock. They are then forced to trade at that price when phoned by brokers.
In contrast, order-driven trading will see the formation of a single order book, where brokers will input on screen orders to buy and sell specific amounts of shares. These trades will then be "matched" automatically. People will deal without knowing necessarily who they will be dealing with.
The Stock Exchange says this will bring greater speed, efficiency and visibility to the trading process: "This order-matching system of trading will help to meet the up-to-the-minute needs of today's market users and play a vital part in maintaining London's position as Europe's leading financial centre."
Such a system already operates in London, via ann American-owned company called Tradepoint. Such competition to the Exchange is another reason why Parliament, the Bank of England and others would like to see a speedy introduction of order-driven.
This new system sweeps away the need for market-makers. It may also diminish the profile of the smaller players, since their names will not be displayed on the new, anonymous system.
It also transforms what was until recently a two-week long, paper and phone-based trading system into a near instantaneous electronic one. Combined with the introduction of Crest, the Bank of England's automated share settlement system, hardly a human being will be involved throughout a transaction.
The old quote-driven system will survive in tandem with order-driven - for the time being. Some expect order-driven to be extended to the smaller FTSE 250 companies as early as next year.
The complexities of introducing the new framework suggest that the winners will be those houses which have the money and expertise to build the new computer systems needed for such trading. The Americans already use order- driven trading, and this would suggest that integrated houses like Goldman Sachs and Morgan Stanley will have an advantage over the British market- making establishment.
Except that they won't. In a typically British compromise, the new system will preserve an important facet of the old system which will be of huge value to the market-makers: block trading.
We now come to the vexed issue of "transparency", another innocuous word which can raise the blood pressure of brokers, MPs and institutions alike.
One of the main groups driving for order-driven trading in the UK were American institutions, eager to see the lower brokers' margins and increased volumes that it would bring.
The Stock Exchange is worried about large international companies shopping around for the easiest and cheapest stock market to buy and sell shares in. It says: "Investors - particularly the large global institutions - buy shares in the markets in which they can trade in large amounts of stocks, at good prices and where dealing costs are low and the process is visible. That is what the electronic order book is designed to deliver."
But the market-makers have won an important concession: they will still be able to delay announcing block trades of shares over a certain value.
This traditional privilege exists because once the market knows a house is planning a particularly large trade, it can move the price against that house. Significantly, the argument about just how big block trades should be before they qualify for this is still raging, and is likely to continue for perhaps another eight weeks.
The American institutions have found that, far from enjoying pure order- driven trading in London, they will still have to deal with those pesky market-makers in a new guise.
It should not be forgotten how much resistance the very idea of order- driven aroused in the City when Michael Lawrence, the former head of the Exchange, proposed it just over a year ago. He was ousted for his pains. The market-makers who got rid of him are now determined to keep at least the block trading aspect of the new scheme.
Another quirk of the proposed new hybrid system is that the old UK market- making establishment which stands to lose so much, and which ousted Mr Lawrence, is now mostly owned by overseas institutions, which are enthusiastic about order-driven.
Smith New Court now nestles in the bosom of Merrill Lynch, the US securities behometh. Kleinwort Benson has fallen to Dresdner Bank in Frankfurt, while Warburg now has SBC in front of its name.
It is no coincidence therefore that Merrill Lynch and SBC Warburg have been most vociferous in pressing order-driven's cause. The same cannot be said of BZW and James Capel, the broking arms of British-based banks Barclays and HSBC respectively. NatWest Markets, despite its recent pounds 90m options blooper, is keen on the changes, and is also pushing hard to expand in the US, the home of order-driven.
This leaves a second tier of market-makers who will have to work hard to survive competition from the big boys. Houses like Societe Generale Strauss Turnbull, Aitken Campbell, Bear Stearns, Credit Suisse and Lehman Brothers fall into this category. Then there are the agency brokers, houses without market-makers who merely buy and sell on behalf of clients. These include Cazenove, Panmure Gordon and Schroders.
While those in the big houses argue that the agency brokers will "have their toes trodden on by the investment banks", Peter Hoeman, director of European Sales and Trading at Schroders Securities, says the new system "should be good fun".
"I think the agency trading houses will benefit. There will be a huge shake-out among the fully integrated market-making firms, and I think the business will be spread more evenly. Orders will be more driven by analysts and research. It will be a massive learning curve for everyone."
It certainly will. Not least for those market-makers who have just signed up to a new mortgage for that fancy town house. Wherever the axe falls, one thing's for certain; the outplacement specialists will be busy.
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